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Fund of Hedge Funds, Manager Selection, and Due Diligence

One of the main reasons that more and more institutional investors, particularly endowments and foundations, include hedge funds in their portfolios is the expected diversification benefit, given the existing array of investment opportunities. In the U.S., these institutions are still increasing their strategic allocation to hedge funds, despite the fact that hedge funds as a whole have underperformed the broad long-only equity market recently. They are seeking top managers in this space and determine allocation in strategies and styles to best position themselves.

In response to institutional investors’ never-ending searching for diversification, the investment vehicle of fund of funds emerged, with the first one established by Adams Street Partners in 1979. A fund of hedge funds a portfolio that consists of shares in a number of hedge funds. A superior fund of hedge funds manager will performance the functions of portfolio construction, manager selection, due diligence, risk management and monitoring of the hedge funds in the portfolio. Like allocation in any asset classes, a fund of hedge funds portfolio also seeks to invest in strategies which have a low correlation to each other, thereby maximizing the expected return under all market conditions. According to BarclayHedge Alternative Investment Databases, the total assets under management in fund of hedge funds was $479.8 billion as of the second quarter of 2013.

Direct Hedge Funds or Fund of Hedge Funds?

Below is a popular methodology on the “University Street,” and many professors have utilized this approach to illustrate the optimal level of diversification in hedge funds portfolios.

This approach involves running regression models on four independent variables, which are:

  1. Sector focus
  2. Asset class focus
  3. Geographic focus
  4. Investment style

Then each variable is against three performance measures:

  1. Average return over the respective benchmark
  2. The Fung and Hsieh seven-factor model alpha
  3. Information ratio

In this experiment, for the purpose of controlling survivorship bias and backfill bias, researchers included dead funds and excluded the first 18 months’ performance. As a result, there were a total of 6,985 distinct hedge funds and fund of hedge funds in the universe.

In direct hedge funds, this experiment has found and confirmed significant positive relationships between performance with both sector and asset class diversification while significant negative relationships with both style and geographic diversification.

In fund of hedge funds, however, this experiment has discovered mixed results: 1) sector diversification positively correlates with returns; 2) geographic diversification negatively correlates with returns across some measures; 3) fund of hedge funds’ performance is negatively associated with asset class diversification. Furthermore, the failure rates of fund of hedge funds increase with style diversification.

Some investors may also be interested in how diversification relates to the incentive structure. In this regard, a factor model that incorporates fees and a high-water-mark dummy variable is a quick tool. One of my most recent projects suggests that higher fees are associated with diversification across all variables except geography, which carries a negative correlation.

Is There an Optimal Number of Managers to be Held in a Fund of Hedge Funds?

In equity space, based on empirical research, the optimal number of stock holdings in a portfolio is approximately 20; each additional stock would result in a loss in the true risk-reduction effect. Similarly, with regard to hedge fund of funds, a portfolio of around 15 funds is optimal for standard deviation reduction, but this may also result in lower skewness and an increased correlation to the stock market. A recent study suggests that the main culprits for the lower skewness in a hedge fund portfolio are the fixed income arbitrage and event-driven strategies, but the optimal number of hedge fund managers to be included is also 15 – 20, as hedge fund of funds have the same liquidity and dis-economics of scale problems as most equity funds. This range is sufficient to beat the benchmark while not losing variance-reducing effect. Therefore, by examining the portfolios of fund of hedge funds across the industry, investors can come with the conclusion that the majority of fund of hedge funds are over-diversified.

Excess diversification results in undesirable side effects in the higher moments of the return distribution. It increases the tail risk exposure of fund of hedge funds especially when the extent to which hedge fund returns are smoothed is counted. The Hedge Fund Research (HFR) database confirmed that the average fund of hedge funds are more exposed to tail risk, and the increase in tail risk is accompanied by lower returns.

Manager Selection and Due Diligence

As of the second quarter 2013, there are over 10,000 hedge funds – more choices for investors but also far greater chance of picking a bad one. Manager selection is particularly critical in the hedge funds space because the analyses of potential hedge funds allocation boil down to the evaluation of the value proposition of these funds as they reflect in their respective investment philosophy, investment objectives, and particular terms. Best-in-class hedge funds exhibit the characteristics of sustainable alpha-generative security selection and active portfolio management expertise.

We have seen hedge fund frauds and blow-ups headlines more frequently than ever, but not necessarily the warning signs. Calling on industry contacts is no longer an effective means of conducting due diligence; rather, a systematic due diligence on management combined with operational due diligence allows for a definitive reduction on such blow-up risk. For investors and investment advisors, assessing managers is more about a “fiduciary duty.” Due diligence is a way to discovering investment managers’ past behavioral patterns, which will greatly enhance the investment decision-making while learning how to recognize these patterns is critical.

There is a large number of due diligence items specific to hedge funds that investors and investment advisors should check and assess. As part of the evaluation process, investors should be familiar with the attributes that each fund offers and ask themselves how much risk they are willing to take for these attributes. At every interview and meeting, investors and advisors should be well-prepared, conversational, and avoid asking yes/no questions (unless they expect yes/no answers). In addition, investors and advisors should and always ask for specifics and examples.

  1. Background of the firm, investment team, and each investment professional
  2. The strategy and product information
  3. Performance of the strategy and whether the performance record is consistent.
  4. The manager’s asset allocation and investment style
  5. The manager’s capability and willingness to do thorough due diligence work on investments
  6. How the portfolio is constructed and managed over time
  7. Risk management and the monitoring process
  8. Administration- and operations-related concerns
  9. Client reporting and communication-related
  10. Compliance and legal issues

Generally speaking, the more identifiers investors can find, the more relevant their results will prove. Besides, there a few points for investors to consider:

  1. Broad searches should be supplemented with targeted searches of the regions where the subject manager has lived and worked. In terms of legal issues, investors should obtain actual documents in order to determine the import and outcomes of the suit; thus they can reasonably assess whether it relates to the subject manager or simply someone else with the same name.
  2. Most regulatory searches, disciplinary actions, and disclosure events can be done online, but investors must conduct manual searches to fill in gaps left by online resources. Databases are simply tools – vastly different results may be found depending on who does the research.
  3. Biographical errors of omission can be a powerful indicator of future problems. In this regard, investors should look for inconsistencies in biographical assertions versus what the news is reporting. Make sure to seek sources for independent interviews.
  4. In terms of fees, hedge funds carry management fees, performance fees, fund expenses, and indirect costs. An effective due diligence looks at the full carrying costs of the investment opportunity. Management fees are set up in a way to allow the manager to run the business, so it should not be a primary source of profit.
  5. If decide to use information and data from news, then make sure to use multiple news databases; cross-check, compare, and contextualize news data.

There are no shortcuts to due diligence; comprehensive due diligence means attending to details and it takes time. At the end, the warning signs are typically: biographical misdeeds, litigation, personality issues, ethics, and multiple job switches.

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